INTERNATIONAL: RMB reform is bullish for the dollar

Analysis

The dollar has staged an impressive rally in 2005, enjoying more than 10% appreciation against the euro. This owes in part to US monetary tightening from June 2004 until the present. Whenever markets expect a softer tone from the Fed, for example, in the wake of weak US data, the central bank answers with another rate increase and relatively hawkish forward-looking comments. Also at play is the weakness in euro-area growth and signs of softening in UK growth, pointing to interest rate cuts in these two economies.

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Bearish factors. The fundamental sources of dollar weakness, which seemed to be dominant in 2004, are still in place. There is a large and persistent current account deficit and a sizeable overhang of dollars in international portfolios, both private and official. While the US external net position has stabilised as a proportion of GDP, this has arisen out of a valuation change of US-owned assets denominated in foreign currencies, rather than an improvement in the US external balance (see UNITED STATES: 'Wealth effects' fuel debt growth - July 21, 2005):

• External deficit. The US current account deficit will exceed 6% of GDP in 2005, driven in part by a continuing budget deficit, though there will be significant improvement this year.
• Portfolio balances. The cumulative effect of the current account deficit is an accumulation of dollars in overseas portfolios. There is concern that overseas central banks, who hold about one-third of external holdings of dollars, will seek to diversify their reserves.

Continued strength. An exchange-rate-driven adjustment in the current account does not yet seem to be at hand. In the closer term, short-run macroeconomic behaviour and interest rate differentials should continue to play an important role in currency movements. The vigorous performance of US GDP compared with the euro-area suggests that growth differentials will continue to support the US currency. Added to this, doubts over the durability of European Monetary Union could buffet safe-haven and diversification allocations out of the dollar and into the euro (by private and official investors) (see ITALY/EU: How a crisis could force Rome to quit euro - July 14, 2005).

The Bank for International Settlements has recently pointed out that interest differentials have become an increasingly important influence on exchange rates. The growth of carry trades operations, based on uncovered interest differentials and a high level of turnover in the foreign exchange market, has made currencies more sensitive than previously to differences in short-term rates. In 2004, low US interest rates encouraged borrowing in dollars to hold foreign currencies, contributing to a weak dollar. As US interest rates have risen in 2005, these positions have been unwound and the dollar has strengthened.

Rate outlook. US short-term nominal interest rates are set to continue rising, probably bringing the US Federal Funds target rate to 5% in June 2006 (see INTERNATIONAL: Global economy may need new motor - June 8, 2005). Euro-area and UK interest rates during this period seem likely to fall or remain constant. Combined with economic growth differentials favouring the US economy, this suggests a resilient dollar throughout the period. Nevertheless, there are risks to the US interest rate policy:

• Because of unusually high personal sector debt loads, the Federal Reserve must proceed gingerly in removing the current monetary stimulus (real rates remain unusually accommodative) so as not to put undue strain on disposable income.
• It must also not raise rates high enough to undermine yields on real estate, provoking a correction in US housing markets.

Neither of these seem imminent. Price pressures show no sign of forcing a faster pace of tightening from the Fed. Inflation figures adjusted for energy and food show remarkable quiescence, demonstrating a de-linkage from oil price inflation. Even here, the energy component of consumer prices will return to earth as the base period for year-on-year calculations comes closer to current prices. US import price indices will also reflect the strength in the dollar.

Demographics. In explaining the strong dollar, one theory gaining currency is the demographic profile in East Asia. Sanjeev Sanyal of Deutsche Bank argues that the world is facing a decades-long savings glut as working-age populations in the developing world build up savings surpluses. In such conditions, monetary authorities in the OECD will enjoy benign price pressures, allowing a relatively relaxed policy stance. Analytically, the danger this raises is in asset price inflation. Yet, given the lack of consensus on the role of monetary authorities in restraining asset prices, this should not produce a faster hike in interest rates.

The demographic thesis is not unlike the 'Bretton Woods II' hypothesis, wherein East Asia undervalues its currencies in order to produce repeated trade surpluses and thus absorb surplus labour into the global economy. As the argument goes, only as this process nears completion in China and India will the dollar stop enjoying official inflows associated with reserve accumulation (assuming that the dollar remains the main currency of global invoicing).

Renminbi reform. By extension, it is only when the Chinese labour market begins genuinely to tighten that the renminbi can appreciate in real terms. The implication is that Beijing has far less ability to control the real exchange rate than policymakers in Washington appreciate. Given the size of the labour market, and the household proclivity to save, a swift appreciation might only court deflation, resulting in an unchanged currency value in real terms. The fact that the domestic monetary consequences of rapid reserve accumulation thus far have been entirely manageable hints at the underlying dynamics (see CHINA: Monetary conditions suit RMB-dollar peg - May 17, 2005).

The upshot is that the US dollar is unlikely to stop receiving support from the Chinese currency regime anytime soon. Indeed, speculative pressures could ensure that the pace of dollar reserve accumulation accelerates, particularly given the outlook for an expanding trade surplus (see CHINA: Trade surpluses set to grow - July 26, 2005). The 'basket' aspect of the Chinese currency reform offers no panacea, as the trading band against the dollar remains explicit at plus or minus 0.3%, and the authorities will not allow a full movement to the 0.3% limit on most trading days (see CHINA: Beijing executes a shrewd currency reform - July 22, 2005).

Outlook. The dollar might also benefit in the short term from changes to US tax law, which are encouraging repatriation of US capital held abroad. Such effects should be seen as a one-time change; fundamental forces should become stronger as these wane. On balance, the short-term prospects are for continued but limited strengthening against the euro and sterling, given the widening differentials in growth and interest rates (see UNITED STATES: 'Relative stability' ahead for dollar - May 12, 2005). In the medium term (ie from 2007), weakness should return as the balance of payments becomes the dominant force in the exchange market. Continued support from China and its neighbours will still cushion the extent of any decline.